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What Is An Allowable 1031 Exchange Closing Cost?

As we’ve seen first-hand, there are many tax issues which come up when contemplating a Section 1031 exchange. In the past, we’ve discussed state taxation vs. federal taxation, leasehold improvement exchanges, reverse exchanges and the identification rules. All of these issues are important and should be studied carefully in order to ensure strict compliance with 1031 guidelines. In this post, we will discuss the tax considerations triggered by so-called “allowable closing costs” in a 1031 exchange. As will be shown, closing costs are a substantial piece of the 1031 puzzle: these costs will be a factor in essentially every exchange (except possibly direct swap exchanges) because they are a natural consequence of the sale of real estate. 

When Closing Costs Become An Issue

When someone sells real estate, the seller typically incurs a variety of expenses.  These relate to the different aspects of the disposition. For instance, a seller will usually need to pay local real estate transfer taxes and local property taxes.  Real estate broker fees, survey costs and title update costs are also common. All of these different costs show up on the real estate settlement statement.  That’s the document which provides a succinct summary of all of the costs associated with disposition of the property. How do these costs affect a 1031 exchange? In particular, how do these costs affect the target price for the replacement property to achieve full tax deferral? Let’s first go over some of the main closing costs in an exchange.  Thereafter, we’ll discuss in detail how taxpayers can deal with such costs. 

Allowable vs. Non-Allowable Closing Costs 

As mentioned, the closing costs of a transaction will show up on the settlement statement. The number and types of closing costs will vary from transaction to transaction.  Nonetheless, all dispositions of real estate will share many costs in common. In a 1031 exchange, the pressing concern is always identifying which costs are eligible to be paid with exchange funds.  If a particular cost is eligible, then the taxpayer will not incur a tax liability on that payment.  If, however, a given cost is ineligible, then paying it with exchange proceeds will result in a taxable event.  

Allowable 1031 Exchange Closing Costs

For the most part, there isn’t too much uncertainty among facilitators regarding the eligibility of most closing costs. In other words, for most costs, there is agreement on the matter of whether they are “allowable closing costs”.  Every now and then, though, an atypical expense requires an expert opinion regarding its eligibility. That’s usually performed by a tax attorney or Certified Public Accountant.

The following are some of the more common closing costs allowable in a Sec. 1031 like kind exchange:  

• Broker’s commissions; 
• Real estate agent commissions; 
• Title transfer taxes;
• 1031 exchange facilitator fee; 
• Owner’s policy title insurance fees; 
• Escrow fees;
• Attorney’s fees; and 
• Title recording fees.

Because these fees are considered allowable, the taxpayer will not incur a tax liability if they’re paid with exchange proceeds. In turn, this means they won’t affect the target price of the replacement property to create full tax deferral. Suppose that a given taxpayer conducts a 1031 exchange and incurs $50,000 of allowable closing costs. When the taxpayer uses exchange proceeds to pay $50,000 toward these costs, this sum will not need to be recaptured on the price of the replacement property to avoid taxable boot.  

Non-Allowable Costs Create a Taxable Event

Non-allowable closing costs, however, will create a taxable event. Let’s assume that a given taxpayer incurs $25,000 of non-allowable closing costs in an exchange.  If they’re paid using exchange proceeds, they’ll be treated as boot from the exchange and thus be subject to tax. From a tax perspective, it’s like the taxpayer took $25,000 of boot from teh exchange and then paid these expenses. This means that the taxpayer will incur a liability based on the $25,000.

Here are some common non-allowable closing costs: 

• Costs and fees associated with acquiring loans;
• Security deposits;
• Prorated rents;
• Insurance premiums;
• Property taxes;
• Fees associated with lender’s title insurance;
• Lender’s appraisal fees; and
• Lender’s inspection fees.

Paying Tax with Exchange Funds or Outside Funds 

After characterizing closing costs as either allowable or non-allowable, the next issue is how to handle their payment. For allowable exchange expenses, paying these expenses with exchange proceeds is clearly the best solution. The trickier question is how to handle non-allowable like kind exchange proceeds. Should you pay off these closing costs with exchange proceeds and then take the tax hit? Or, conversely, should you pay them outside of the exchange with non-exchange funds? Ultimately, the course of action you choose will depend on all of the relevant facts of the given scenario. Paying off non-allowable closing costs with outside funds can confer a distinct advantage.  Specifically, it avoids taking any boot out of the exchange.

What’s the Issue?

Think about it.  If you take $25,000 out of the exchange to pay non-allowable costs, you’ll pay taxes on the $25,000.  That’s considered a recognized capital gain. If you’re subject to a blended tax rate of 30% on the gain, you’d end up paying $7,500 in tax. If you brought in outside funds to cover these costs, though, you’d simply take a hit of $25,000.  Then the $25,000 of exchange funds would be preserved.  That could, in turn, be used for the acquisition of replacement property. The result would be that the $7,500 liability would be avoided altogether.

Get Experienced New York Tax City Attorney Help

Again, the optimal course of action will always depend on the specifics of the situation. If the taxpayer is in a higher income tax bracket, paying closing costs with exchange proceeds may be desirable. At Mackay, Caswell & Callahan, P.C., we understand that the complexity of 1031 like kind exchanges can be overwhelming.  That’s why we make it a priority to break things down in the simplest way possible. If you need counsel on an upcoming 1031 transaction, please reach out.  One of our top New York City tax attorneys will give proper attention to your case immediately.  Or, should you be located in another part of New York State, we can still help.  Just call one of our offices in Albany, New York City, Rochester or Syracuse.  We’re there to help you right away!  

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